Dissecting the SaaS business model

Three SaaS companies, Netsuite, Successfactors and Constant Contact are preparing for IPO. This is great news as I get to tick off a “win” on one of my 6 predictions for 2007.

Jason Wood did a stellar writeup of the Netsuite S1 and Jason Corsello did a good note on the Successfactors S1. I thought I'd take a comparative look at all of them.

What struck me with all three companies was the losses. The first order explanation is quite simple: all the companies spend a ton of money on sales & marketing (between 65% and 100% of revenues). Most of these businesses are the farthest thing from the oft discussed but seldom witnessed “pull model” that’s supposed to lead to superior profits.

The root cause for the losses is a little more subtle. In a recent article, McKinsey consultants asserted that the primary cause is scale. In fact they go so far as to say that these scale economies are nearly identical to those of on-premise software companies.

On the surface this appears to be a reasonable explanation. Successfactors had $36m in 2006 revenues and spent roughly 100% of revenues on SG&A. Netsuite is at $65m in 2006 revenues and spent 78% of revenues on SG&A. But I think this is a bit off. Salesforce is at $309m in 2006 revenues and still spent 67% of revenues on SG&A. Rightnow was at $110m in 2006 and still spent 71% of revenues on SG&A. Meanwhile, many smaller on premise companies like Aspen Technology, Quest Software and VMWare keep these costs around 40-50% of revenues and turn an operating profit of 10% or so.

The true factor driving SG&A for these SaaS companies is growth, not scale. This is logically consistent as the economics of most any subscription business is based on the cost to acquire a customer versus the future returns of that customer relationship. I took the financials for all four companies and lined them up not based on year but based on when they are at a comparable size (comparable stage in their evolution). They look like this:


You can see that SG&A spent in the prior year (cost to acquire customers) correlates very well to growth in the subsequent year (returns from customers acquired). So, as long as you believe there’s growth left in your market, keep spending to capture that growth. To prove the point, Successfactors had an interesting period in their fiscal 2004 where they seemed to prematurely press for operating profits by taking SG&A down from 108% to 75% of sales. They were horribly punished in the following year with tepid growth of 35%. They corrected the error the following year and growth sprang back to life.

I created a simple ratio I called “growth efficiency.” This ratio is growth rate in a given year divided by the SG&A % from the prior year. Essentially this evaluates how much growth is generated by a point of margin spent on SG&A in the prior year. I think this ratio is a pretty good indicator both SG&A spend efficiency and is probably also a pretty good indicator of long term profitability. A few observations on the ratios for the 4 companies:

Salesforce had reached a fairly stable equilibrium where a point of margin spent on SG&A returns a point of growth the following year. However this has been deteriorating over the past 2 years. If the high end of Salesforce’s 2008 guidance holds, they will be down to a .69 ratio, equal to or worse than anyone else in the group. Interestingly, this is trending down at a time when Salesforce has been raising prices through various premium offerings that can now drive the user/year fee as high as $2,350. I think there are lots of interesting theories to explore here.

Successfactors’ ratio is all over the map due to their experimentation, but in 2005/2006 a point of margin spent on SG&A returned a point of growth. I think it’s too soon to extrapolate any long term trends for Successfactors.

Netsuite has been a consistently less efficient business. A point of margin spent on SG&A currently returns only 2/3 of a point of growth the following year and this was 1/2 a point of growth a few years back. That reinforces my theory (and persistent rumors) that Netsuite should have a tougher time acquiring customers than a Salesforce. Financials is a more centrally controlled purchase decision and is more likely to go through a comparative evaluation. In their defense, the picture has been steadily improving.

Constant Contact has the best business of the four. A point of margin spent on SG&A gets you 1.4 points of growth. This with a product whose average selling price is just $34/month. This also makes sense as e-mail marketing services for SMB companies has got to be the ultimate impulse buy. Constant Contact uses no direct sales force and generates almost all revenue through marketing campaigns and channel partners.

The pull model is as elusive as ever, but Constant Contact seems to give us a few hints as to how it's supposed to work.

[SaaS], [Business Models]